David A.

Rosenberg July 3, 2009

Chief Economist & Strategist Economics Commentary
drosenberg@gluskinsheff.com
+ 1 416 681 8919

MARKET MUSINGS & DATA DECIPHERING

Lunch with Dave

THE CROSS OF THE GOLDEN CROSS IS GETTING CROSSED UP
IN THIS ISSUE
The S&P 500 is clearly struggling and on Thursday closed below its 50-day
moving average and is barely hanging on to its 200-day m.a. As we have said • The cross of the golden
before, the bounce in the market was a two-month wonder that looks to have cross is getting crossed
been completed in early May and what is ironic is that most of the street up
strategists turned outright bullish after the complete move had already been • Strange way for a
made. But the volume has not been there, the green shoots are fading (with recession to end
both auto sales and employment disappointing in June) and it may be important
• Jobless claims point to
from an “all the good news is priced in” standpoint that since the stress test further big declines in July
results were announced the broad market has done little more than move
• Fiscal stimulus or
sideways.
restraint?
The CRB is also struggling now at both the 50-day and 200-day m.a.’s. The U.S. • Is ISM the big loser?
dollar has bounced back despite the weak economic data and the reason for • The financial crisis is over
that is because heightened risk aversion, which is what we are seeing now, … Really?
tends to occur alongside a shift towards liquidity preference, and many investors
may not like the greenback for a whole host of reasons, but liquid it is.

Note that the Baltic Dry Index is coming off a two day 2.2% slip, which could be a
near-term caution sign for the commodity complex. The chart of gold shows a
triple-top and it too is converging on the 50 and 100-day moving averages – the
rebound in the U.S. dollar and news that jewellery demand out of India is very
weak (see page 20 of today’s FT). This should help set up a return for the
Canadian dollar into a 80-83 cent band (as an aside, the higher end represents
the 200-day m.a.).

The 10-year T-note yield, after the latest rally, is at a critical juncture of its own at
3.5% – hugging the 50-day moving average and a break of that could well set up
a retest of 3.08 - 3.15%, which is the range on the 100-day and 200-day moving
averages. As an aside, the bubble of the year candidate may well go to the
Chinese stock market, which has soared 70%. Nothing else comes close.

Enough of the technicals, let’s move to the fundamentals.

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July 3, 2009 – LUNCH WITH DAVE

STRANGE WAY FOR A RECESSION TO END

Has a recession ever ended with U.S. payrolls sliding 1.3 million over a three- The June U.S.
month span? The answer would be “no”. employment report
had deflation
The June U.S. employment report had deflation thumbprints all over it. You thumbprints all over it
don’t have to take my word for it, have a read of San Francisco Fed President
Janet Yellen’s speech on June 30 when she dared to utter the “D” word (see
below). And that was before the release of the payroll data, which contained
disturbing signs of weakness on many fronts.

The headline U.S. nonfarm figure came in at -467k compared with -350k
consensus forecast and the back revisions were negligible (+8k). Also keep in
mind that the Birth-Death adjustment showed that miraculously, 185,000 jobs
were created by new business formation, which was 20,000 more than a year
ago – you really cannot make this stuff up. Be that as it may, at no time in the
1980, 1982, 1990 or 2001 recessions did we ever come close to seeing such a
detonating jobs figure as we did on Friday, not even at the depths of those
downturns, and yet we have a whole industry of ‘green shoot’ advocates today
telling us that the recovery has already arrived.

We saw a market commentator on the front page of today’s NYT stating “It looks
shockingly bad compared to last month, but it is better than April when the
economy shed 504,000 jobs. The trend is much better than when we started
the year”. We can understand the human need to be optimistic at all times, but
in the money management business, it is vital to constantly do reality checks.
With the global economy coming out of the abyss at the turn of the year, and
with credit conditions far better than the total freeze-up back then, why should
we still be seeing job declines of between 700k and 800k? Is that the new
benchmark for the economy? The reality is that the Lehman collapse was nine
months ago and the peak of the fallout was five months ago. Think about that,
the economy was in recession for over a year by the time the markets really
began to fall apart at the turn of this year, and since the peak of the angst, the
economy has still shed over 2½ million jobs, which is more than what was lost in
the entire 2001 tech-wreck-downturn.

So while we are no longer experiencing an earthquake, what we are enduring

are the aftershocks, not green shoots. There is still up to $5 trillion of consumer
While we are no
and mortgage-related debt that has to come out of the system based on the new longer experiencing
and lower level of assets and net worth on the household balance sheet, and an earthquake, what
companies are adjusting their order books, output schedules and staging we are enduring are
requirements to this new paradigm of credit contraction. It should not be lost on the aftershocks, not
anyone that this is the first time since the 1930s depression that the private green shoots
sector job losses posted in the economic downturn more than wiped out all the
gains from the prior expansion.

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This is a totally new experience for analysts, economists and strategists, which
may be one reason why so many pundits missed calling this cycle for what it is, As always, the devil
or perhaps for what it is not, a garden-variety recession, where little rules-of- was in the details in
thumb like the ISM or ECRI can be relied upon to call the turn. This time around, Thursday’s nonfarm
the signpost will come from more esoteric indicators such as home inventories, payroll report
the savings rate, debt-service ratios, household balance sheet growth, and liquid
assets relative to non-liquid assets on commercial bank balance sheets. That is
the big picture.

Back to the smaller picture (the data). As always, the devil was in the details in
Thursday’s report. In almost every industry, job losses were deeper in June than
they were in May. The diffusion index fell to 28.6 from 31.0, which means that
nearly three-quarters of the corporate sector is still in the process of shedding
jobs. The Household Survey showed a 374k job decline, and all centered in full-
time jobs. In fact, we have lost a record 9 million full-time jobs this cycle, more
than triple what is normal in the context of a post-WWII recession, and the over
2 million pushed onto part-time work (and the number of people now working
part-time because they have no other choice due to the weak economy has
more than doubled).

This in turn has taken the total hours worked in the private sector down to a new
record low of 33.0 hours in June from 33.1 hours in May. In fact, aggregate Aggregate hours fell
hours fell so much in June that the decline was equivalent to over an 800k job so much in June that
slice! Just to put the entire labor market picture into a certain perspective; the decline was
aggregate hours worked, which closely tracks real GDP growth, fell 0.8% in June equivalent to over an
(that is a 9.2% plunge at an annual rate), which was the steepest decline since 800k job slice
March, and not once did a recession ever end with this metric as weak as it was
last month.

When we say that deflation has gripped the labor market, we are not
exaggerating. Average weekly earnings – the proxy for wage-based income – fell
0.3% in June and have been flat or down in three of the last four months.
During this interval, they have deflated at a 1.6% annual rate – versus a +1.8%
trend a year ago and +5.2% two years ago.

Moreover, judging by the lingering – indeed, accelerating – weakness in labour

demand, these deflationary pressures in the labour market in general and
wages in particular can be expected to persist. In addition, the implications for
consumer spending once the fiscal stimulus subsides in the second half of the
year are clearly negative, with similar implications for corporate profits and the
equity market, which are de facto priced in a V-shaped earnings recovery. The
average duration of unemployment gapped up by two weeks to 24.5 weeks –
both the monthly increase and the level reached new record highs. The number
of unemployed people that have been looking for a job with futility for the past
six months rose 433k to a new all-time high of 4.4 million. Almost one-in-three
of the ranks of the unemployed have been looking for work now for the past six
months and still can’t find one. It is remarkable that anyone can be serious
about ‘green shoots’ in this labour market backdrop.

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When recovery does come, the record number of people that have been pushed
into part-time work are going to see their hours go back up, which will be good
for them, but not so good for the 100,00 - 150,000 folks that will be entering What makes this cycle
the labour force looking for work with futility. The unemployment rate is
different is the
permanency of the job
probably going to rise through 2010, which is going to pose a challenge for
losses
incumbents seeking re-election in the mid-term voting season. It may also prove
to be a challenge for Ben Bernanke’s re-appointment chances this coming
February. As we said above, companies have permanently reduced the size of
their operations with a knowledge of how much credit is going to be available to
them in the future to survive because the financial sector is going to be
operating under more supervision and regulation and leverage ratios, which
means the funds available to support a given level of GDP is going to be
measurably smaller than what we had become accustomed to during the
secular credit expansion that really began in the mid-1980s, only to turn
parabolic during the ‘ownership society’ era of 2002 to 2007.

What makes this cycle “different” is the permanency of the job losses – many
are not coming back. For example, the number of people unemployed who are
not on “temporary layoff” rose 172k in June and the tally is 1.2 million over the
past three months to total a record 7.9 million. Three-in-every-four workers who
were fired over the past year were let go on a permanent, not a temporary,
basis. A record 53% of the unemployed today are workers who were displaced
permanently – not just temporarily because of the vagaries of the traditional
business cycle. That means that these jobs are not going to be coming back
that quickly if at all when the economy does in fact begin to make the transition
to the next expansion phase. This, in turn, means that any expansion phase is
going to be extremely fragile and susceptible to periodic setbacks.

There may well be job growth in the future in health care, infrastructure, energy
technology and the like, but we can say with a reasonable amount of certainty
that there are a whole lot of jobs in a whole lot sectors where jobs lost this
recession are not going to come back. For example, the 580k jobs lost in
financial services, the 320k jobs lost in residential construction, the 1.7 million
jobs lost in durable goods manufacturing, the 1.1 million jobs lost in the
wholesale/retail sector, and the 380k jobs that were lost in the
leisure/hospitality industry. That is over four million jobs right there that were
shed this cycle that are not likely to stage a comeback even after the recession
is over. To show you how big a number four million is, we didn’t create that
many jobs in the prior expansion until it reached its fourth birthday towards the
tail end of 2005.

The employment-to-population ratio just fell to a 15-year low of 59.5%. For it to

go back to where it was at the peak of the last expansion, when there were
legitimate cyclical inflation concerns, the economy would have to generate
roughly 10 million jobs from where we are today. So watching for inflation in
coming years, and we say this with all deference to the Fed’s bloated balance
sheet, which two years into this easing cycle has yet to reignite the credit cycle,
is going to be akin to watching grass grow. Have fun.

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The degree of slack in the labour market is without precedence, and this
widening gap between the demand and supply for labour, as we have seen in The degree of slack in
Japan, is very likely to continue exerting downward pressure on wage rates. the labour market is
With the fiscal deficit at 13% of GDP and public support for continued deficits without precedence
waning, it is doubtful that the government, which now contributes a record 18%
to personal income, can fill the void indefinitely. Did you know that the White
House said in January that an $800 billion fiscal package would be enough to
bring the unemployment rate down to 7% and that without the stimulus the rate
would be 9%. Here we have the ballyhooed stimulus and the official jobless rate
is 9.5%. Maybe, just maybe, the government isn’t the answer and today’s WSJ
editorial (Tilting at Windmill Jobs) hits the nail on the head on this issue. Fully
nine months after the election, this is hardly W’s recession any longer – even if
the pace of economic activity is very likely going to look like a continuum of W’s
even after the recession part of this post-bubble credit collapse runs its course.

We shudder to think what the consumer spending landscape would look like if
the savings rate was still rising to 15-year highs at a time when incomes were
falling faster than they already are. After all, here we are, into the 19th month of
recession, and consumer spending in the quarter that just finished looked to
have contracted fractionally even in the face of massive help from Uncle Sam.
The U-6 unemployment rate, which includes all measures of excess capacity in
the jobs market, rose again to a new lifetime high in June to 16.5% from 16.4%.
Imagine that 1 in 6 Americans are either unemployed or underemployed, to go
along with the 1 in 8 Americans that are either in arrears or already in the
foreclosure process and the 1 in 10 homes that are still on the market but not
selling. Green shoots, indeed.

JOBLESS CLAIMS POINT TO FURTHER BIG DECLINES IN JULY

To add insult to the injury for the ‘green shoot’ crowd was the news that jobless
claims came in at 614k in the week ending June 27th. This was not far out of Jobless claims adding
line with consensus and the ‘green shooters’ will attempt to save face by insult to injury for the
claiming that this was lower than the 630k print the week before, but the reality
green shoot crowd
is:

• Claims at 614k are still consistent with nonfarm payroll losses of around 400k.

• Claims have been above 600k now for – let’s see – 22 weeks in a row, which
is unprecedented.
• Claims never came within spitting distance of 614k in either of the 1990 or
2001 recessions.
• While continuing claims did fall to 6.702 million from 6.755 million, this likely
reflects the fact that a growing number of people are running out of benefits,
even with the extensions (something to do with the fact that a record 29% of
the pool of unemployment have been out of work now for over six months and
we see from the claims data that 5.7 million people rolled off of the extended
benefit program the week of June 13th).

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FISCAL STIMULUS OR … RESTRAINT?

In that nonfarm payroll report for June, we saw that state governments shed
“All of this is
4,000 workers and have done so in five of the past seven months. And now we
depressingly familiar
have California, the worlds’ 10th largest economy, resorting to issuing IOUs for
to anyone who has
the second time since the Great Depression as it grapples with a $24 billion
studied the economic
fiscal gap. The not-so-Golden state is not alone as seven states in total have yet policy in the 1930s”
to pass budgets in their legislatures even though the new fiscal year has just
begun (and we are talking about large economies like Ohio and Illinois). In sum,
there is a combined $121 billion fiscal shortfall that has to be closed, which
means that much of the stimulus at the federal level is going to be offset by the
drag at the state and local government level. Paul Krugman offers up this little
ditty on today’s op-ed in the NYT (That ‘30’s Show):

“All of this is depressingly familiar to anyone who has studied the economic
policy in the 1930s. Once again a Democratic president has pushed through
job-creation policies that will mitigate the slump but aren’t aggressive enough to
produce a full recovery. Once again much of the stimulus at the federal level is
being undone by budget retrenchment at the state and local level”.

IS THE ISM THE BIG LOSER?

So many pundits rely on this metric it isn’t even funny. It works well in classic
inventory cycles, but not in a credit contraction. So the markets and the street ISM works well in a
economists and strategists declared the recession to be ending because at the classic inventory
beginning of the week, the ISM jumped two more points to 44.8. Interesting to downturn, but not in a
see how that ISM improvement translated into a 136,000 factory payroll plunge credit contraction
and a 1.2% slide in aggregate hours worked in this sector last month.

We see that economists are already penning in an industrial production number

of -0.6% MoM for June (data to be released on July 15). This is what a 44+
reading on ISM brings us (people forget that the ISM is a diffusion index and
treats small manufacturers the same as it treats large ones – it is not an
infallible indicator). So, considering that employment and production make up
two of the four ingredients that go into the NBER recession call, how can the
growth bulls be so sure that the recession ended last quarter (let alone this
quarter)? Yet that is still the growing consensus in the economics community.
The view that the labour market is a lagging indicator is really “old paradigm”
thinking; that may be true in an inventory cycle but is hardly the case in a credit
cycle as job loss and declining wage rates impede progress in terms of
household balance sheet repair and the delinquency/default process.

For bonds, all anyone needs to know is that yields at the long end of the curve
do not ever bottom until the unemployment rate peaks – usually months after,
in fact. So yes, the curve will be steeper for a while longer because of the
massive amounts of government supply coming down the pike, but even a 250
basis point spreads off 3, 6, or 12-month T-bills would still imply a return to a
sub-3% yield on the 10-year T-note at some point. Remember, you can look at
growth, inflation and fiscal deficits, but nothing is as important in determining
the trend in long-term bond yields than the “carry” – in other words, Fed policy.

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(This is why the vast majority of bear markets occur when the central bank is
tightening and why it is that corrections as we just saw this spring occur when
investors, rightly or wrongly, price in Fed rate hikes.)

The oft-cited view that the improvement in the corporate bond market or the
dead-cat bounce in the equity market are leading indicators of future growth – Focus on capital
it’s probably more of a case of pulling back from the brink back in March. The preservation and
corporate bond market was the leading asset class in the 1930s in terms of income strategies
total return generation and the S&P 500 turned in a similar bounce in the
summer-fall of 1932, as it just did from March to May. Yet, despite easy money
from the Fed, massive dollar devaluation thanks to FDR, huge bank bailouts,
and rampant New Deal Stimulus, the reality is that the Great Depression did not
end for another nine years after credit spreads peaked and equity prices
bottomed, and by the end of the 1930s, the unemployment rate was still 15%,
the CPI was deflating at a 2% annual rate, the yield on the long bond was on the
precipice of breaking below 2%, and the level of GDP was still below the 1929
peak. If you bought the S&P 500 in the summer-fall of 1932 because you
feared missing the train after a 60% bounce off the lows, there was no capital
gain for a ‘buy-and-hold’ investor until the final few months of 1942. Either
know how to invest, which means renting the rallies and avoiding the periodic
pitfalls that are typical of a post-bubble credit collapse, or focus on capital
preservation and income strategies.

LIGHT ON THE DATA CALENDAR NEXT WEEK BUT ...

While we will see the University of Michigan consumer sentiment for July on
Friday, the next key economic releases are not until the 14th when we get PPI
and retail sales. So next week the equity market will likely just mark time and
the bond market will be focused on a huge supply infusion – the Treasury will be
selling $136 billion of bills, 10-year TIPS, three-year notes, 10-year notes and
long bonds.

THE FINANCIAL CRISIS IS OVER … REALLY?

Have a look at page C3 of today’s WSJ and tell us if we can really reach that
conclusion – Home Loan Banks See Net Income Decline 51% (hit by $516
million in mortgage writedowns) and Tally Hits 48 As 3 Banks Fail in Illinois (if
only they were “too big”, the Administration would have bailed them out). All in,
the FDIC closed down seven institutions yesterday.

YELLEN AND SCREAMIN’

On June 30, San Francisco Fed President Janet Yellen, as lucid as ever,
delivered a tremendous speech. Lingering recession, muted recovery when it
comes, consumer frugality, and deflation were cited as the major macro risks.
We would tend to agree.

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On the recession:
“I expect the pace of the recovery will be frustratingly slow. It’s often the case
that growth in the first year after a recession is very rapid. That’s what
happened as we came out of a very deep downturn in the early 1980s. Although
I sincerely wish we would repeat that performance, I don’t think we will. In past
deep recessions, the Fed was able to step on the accelerator by cutting the
federal funds rate sharply, causing the economy to shoot ahead. This time, we
already have our foot planted firmly on the floor. We can’t take the federal
funds rate any lower than zero. I believe that the Fed’s novel programs are
stimulating the flow of credit, but they simply aren’t as powerful levers as large
rate cuts, so this time monetary policy alone can’t power a rapid recovery.”

On the recovery:
“History also teaches us that it often takes a long time to recover from
downturns caused by financial crises, 3 in particular, financial institutions and
markets won’t heal overnight. Our major banks have made excellent progress in
establishing the capital buffers needed to continue lending even through a
downturn that is more serious than we anticipate. But they are still nursing their
wounds and credit will remain tight for some time to come.

I also think that a massive shift in consumer behavior is under way — one that
will produce great benefits in the long run but slow our recovery in the short
term. American households entered this recession stretched to the limit with
mortgage and other debt. The personal saving rate fell from around 8 percent of
disposable income two decades ago to almost zero. Households financed their
lifestyles by drawing on increasing stock market and housing wealth, and taking
on higher levels of debt. But falling house and stock prices have destroyed
trillions of dollars in wealth, cutting off those ready sources of cash. What’s
more, the stark realities of this recession have scared many households straight,
convincing them that they need to save larger fractions of their incomes. In the
long run, higher saving promises to channel resources from consumption to
investment, making capital more readily available to retool industry and fix our
infrastructure. But, in the here and now, such a rediscovery of thrift means fewer
sales at the mall, and fewer jobs on assembly lines and store counters.”

On financial fragility:
“That’s a dreary prediction, but there is also some risk that things could turn out
worse. High on my worry list is the possibility of another shock to the still-fragile
financial system. Commercial real estate is a particular danger zone. Property
prices are falling and vacancy rates are rising in many parts of the country.
Given the weak economy, prices could fall more rapidly and developers could
face tough times rolling over their loans. Many banks are heavily exposed to
commercial real estate loans. An increase in defaults could add to their
financial stress, prompting them to tighten credit. The Fed and Treasury are
providing loans to investors in securitized commercial mortgages, which should
be a big help. But a risk remains of a severe shakeout in this sector.”

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On deflation risks:
“Let me now turn to an issue that has lately garnered a great deal of attention —
inflation. Just a short time ago, most economists were casting a wary eye on the
risk of deflation — that is that prices might drop, perhaps falling into a downward
spiral that would squeeze the life out of the economy. Now, though, all I hear
about is the danger of an outbreak of high inflation.

I’ll put my cards on the table right away. I think the predominant risk is that
inflation will be too low, not too high, over the next several years … First of all,
this very weak economy is, if anything, putting downward pressure on wages and
prices. We have already seen a noticeable slowdown in wage growth and reports
of wage cuts have become increasingly prevalent — a sign of the sacrifices that
some workers are making to keep their employers afloat and preserve their jobs.
Businesses are also cutting prices and profit margins to boost sales. Core
inflation — a measure that excludes volatile food and energy prices — has drifted
down below 2 percent. With unemployment already substantial and likely to rise
further, the downward pressure on wages and prices should continue and could
intensify. For these reasons, I expect core inflation will dip to about 1 percent
over the next year and remain below 2 percent for several years.

If the economy fails to recover soon, it is conceivable that this very low inflation
could turn into outright deflation. Worse still, if deflation were to intensify, we
could find ourselves in a devastating spiral in which prices fall at an ever-faster
pace and economic activity sinks more and more.”

On fiscal policy:
“The third concern is that big federal budget deficits might eventually be
inflationary. In my years of teaching at Berkeley, I regularly lectured on the
relationship between fiscal deficits and inflation. A glance at history shows that
many countries with massive structural deficits and without an independent
central bank turned to the printing press to pay off their debts. That’s a recipe
for high inflation and, in some cases, hyperinflation. But I don’t believe the
United States faces that threat. Looking back in history, runaway fiscal deficits
have often been accompanied by high inflation. But, since World War II, such a
relationship has only held in developing countries. In countries with advanced
financial systems and histories of low inflation, no such connection is found …
Consider the case of the large deficits in the United States in the 1980s. We did
not see a run-up in inflation then. On the contrary, the deficits soared just as
inflation was coming down. Those deficits did, however, contribute to higher
interest rates, which made education and investment more expensive. Japan
provides another example. Japan has run very large fiscal deficits through much
of the past two decades, yet its problem is persistent deflation—precisely the
opposite of inflation.

… In sum, although I take these concerns about inflation seriously, I do not

believe that there is a real threat of high inflation in the current situation.
Monetary policy fosters inflation when it loosens financial conditions enough to
create excess demand for goods and services. What could be clearer than the

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fact that right now we need more demand—not less—to offset the slack in labor
and product markets?

If anything, I’m more concerned that we will be tempted to tighten policy too
soon, thereby aborting recovery. That’s just what happened in 1936 when,
following two years of robust recovery, the Fed tightened policy because it was
worried about large quantities of excess reserves in the banking system. The
result? In 1937, the economy plunged back into a deep recession. Japan too
learned that hard lesson in the 1990s, when both monetary and fiscal policies
were tightened in the mistaken belief that the economy was rebounding.”

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